Short Squeezes: A Four-Factor Model

Anticipating and using brief squeezes has grown in recognition as an funding tactic lately. The GameStop short squeeze, galvanized by motivated retail buyers on web message boards, is a vivid instance of this phenomenon.

The best end result for a potential short-squeezer is what we’ll name the short-squeeze trifecta: They need to determine the brief squeeze earlier than it occurs, efficiently experience the inventory as its worth soars on the way in which up, and bail out earlier than the value falls again all the way down to earth.

Shares that find yourself in a brief squeeze are likely to exhibit two well-known determinants: They’ve excessive brief curiosity and are thinly traded. However do different components come into play? We questioned whether or not sure macro circumstances may correlate with larger numbers of brief squeezes or if brief squeezes have been extra frequent particularly sectors.

Our evaluation signifies two further components are related to elevated brief squeeze exercise: elevated market uncertainty and speculative applied sciences with yet-to-be-determined long-term worth.

Strict and Free Brief Squeezes

To check brief squeezes over time, we first needed to develop a technique to determine whether or not they really passed off. Utilizing knowledge from all publicly listed US corporations from 1972 to 2022, we outlined two distinct classes of brief squeezes: “strict” and “free.” A strict brief squeeze is when a inventory’s value rises by 50% to 500% after which falls again all the way down to between 80% and 120% of its earlier worth in the midst of one month. The identical sample happens in a free squeeze however over two months.

This method recognized 1,051 strict brief squeezes and 5,969 free brief squeezes throughout the research interval. The outcomes for strict brief squeezes are offered under. The free methodology demonstrated qualitatively related outcomes.

Strict Brief Squeezes by Yr

The variety of strict brief squeezes diversified significantly over time. A few years had near zero whereas others had greater than 100. The 5 most lively brief squeeze months, normalized by the entire variety of up to date fairness listings, have been February 2021, Could 2020, October 2008, February 2000, and October 1974.

Tumultuous Occasions

What do all these months have in frequent? They fell amid durations of maximum market uncertainty. Inflation and COVID-19 infections have been resurgent in February 2021, for instance. In Could 2020, the pandemic had upended life as we all know it. The worldwide monetary disaster (GFC) and the related panic have been in full swing in October 2008. In February 2000, the dot-com bubble was approaching its speculative peak earlier than starting its subsequent downward spiral. Excessive inflation, oil value shocks, and a extreme recession have been all middle stage in October 1974, and the US Federal Reserve would quickly begin slashing rates of interest, prioritizing financial progress over lowering inflation. So robust instances for the markets and the bigger economic system are usually good instances for brief squeezes.

But-to-Be-Confirmed Know-how

How did strict brief squeezes differ by sector? They occurred most frequently in biotech, with 20 in 2000 and 23 in 2020. These have been the highest years for brief squeezes for any sector. Software program and computing was the second commonest short-squeezed sector.

Strict Brief Squeezes by Sector

The biotech and software program and computing sectors share a heavy reliance on new and infrequently unproven know-how. This makes them extra susceptible to hypothesis, tougher to worth, and, as our knowledge present, likelier targets for brief squeezes.

In contrast, the least short-squeezed sectors are railroads, lodging, life insurance coverage. These all have established, effectively understood enterprise fashions and little uncertainty round their valuations. They’ve little enchantment for potential short-squeezers.

So to find out whether or not a inventory may turn into the goal of a brief squeeze, there are 4 standards to remember: Is the inventory being shorted? Is it thinly traded? Does it depend on unproven know-how? Are macro circumstances particularly unstable?

To make certain, brief squeezes usually are not particularly frequent phenomena, so even when all 4 circumstances apply, the chances of predicting one are nonetheless very lengthy. And as GameStop demonstrates, there are all the time outliers. Furthermore, even when these 4 components assist determine brief squeezes earlier than they occur, their trajectories — how shortly they crest and crash — will all the time be fraught and unsure. Which is why brief squeezes are waves we shouldn’t stake an excessive amount of on catching and using.

In the event you appreciated this put up, don’t neglect to subscribe to Enterprising Investor.

All posts are the opinion of the creator. As such, they shouldn’t be construed as funding recommendation, nor do the opinions expressed essentially replicate the views of CFA Institute or the creator’s employer.

Picture credit score: ©Getty Photos/ cnsphotography

Skilled Studying for CFA Institute Members

CFA Institute members are empowered to self-determine and self-report skilled studying (PL) credit earned, together with content material on Enterprising Investor. Members can file credit simply utilizing their online PL tracker.